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Seed Weekly - Value Investing the Buffett Way

During my honours year at UCT we had to read and summarise all of Berkshire Hathaway’s annual shareholder letters. This was most likely to have the philosophy of value investing indoctrinated into our minds, as it’s a widely utilised investment philosophy – and one you hear most at investment presentations and while studying at university.

Value investors buy companies at prices below their true value. Company value is determined through fundamental bottom up analysis. Typical value indicators are companies with strong balance sheets, low price-to-earnings (PE) and price to book (P ratios and high dividend yields.

Unfortunately, while value investing seems simple, it’s not always that easy and cannot be done 100% through ratio analysis as one also needs wisdom and insight. For that reason it’s best to go back to the source of value investing. Benjamin Graham, a former professor at Columbia business school, is considered to be the father of value investing. If one wants to get into the heart and soul of value investing, two of Graham’s well known books The Intelligent Investor and Security Analysis are a good place to start.

Warren Buffett is his most famous student, and his nuggets of wisdom are found in his annual letters to his shareholders. One can learn a lot from the “Oracle of Omaha” and I thought this to be insightful information to share.

Warren Buffett was born in 1930, and at the age of 83 he is currently still the Chairman of Berkshire Hathaway Inc., the company he took over by way of a share buyout. Interestingly, the company was not started as an investment house; rather formed through two textile companies merging in 1955. Warren Buffett started buying shares in the company in 1962 and in 1964 he was the majority shareholder. Today it operates as a multinational investment holding company.

Some of the highlights found in his letters are his thinking and rationale behind the decisions he makes. Warren Buffett makes investing sound very simple:
• Use your logic.
• Work hard.
• Think clear.
• Be ethical.
• Enjoy what you do, that way you won’t have to work one single day of your life.
• Invest into businesses where tailwinds prevail rather than headwinds.
• Place a lot of weight on measuring managerial economic performance by a company’s return on equity (ROE).
• Buy shares to become a mutual owner in the company – and thereby aim to remain a shareholder forever.
• Measure a company’s performance over the long term – not any given day.

Mr Buffett tries to get a significant stake in a company since; “If something’s not worth doing at all, it’s not worth doing.” he admits that he made mistakes in the past by acquiring businesses – mostly due to miscalculation. However, it is easier to correct your wrongs when you have controlling interest in the company. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past.

Some of his lines of wisdom are indeed very catchy. “Like virginity, a stable price level seems capable of maintenance, but not of restoration” or the Noah principle: “predicting rain doesn’t count, building arks does.”

The first letter dates back to 1977 we will therefore break it up in sections of five years at a time. A one page summary of each year will also be posted onto our website. For what it’s worth – feel free to give it a read and provide us with any insights and comment if you like. This is by no means a comprehensive summary of his work; the full collection of his letters is available at http://www.berkshirehathaway.com. Judging by the appearance of the company’s website (which looks like something from the 80’s) – it is clear that Warren Buffett completely skipped the dotcom bubble. There is much to learn from this man. It is this kind of insight that makes Warren Buffett the most successful investor of the 20th century.

Seed weekly - Investment Journey

Following up on Barry’s report in July that dealt with the opportunity cost of not taking sufficient risk in your investment portfolio, this report will explain the investment journey that you should be prepared for when making investment decisions.

The mention of investment journey is in reference to the upside potential and downside risks that are inherent when choosing investments that have different risk profiles to money market investments. The rationale is that the higher the risk of the instrument, the higher the payoff to compensate the investor for taking on the additional risk. Naturally this is not a linear relationship but generally holds over the long term (in excess of 5-7 years).

The below graph shows the losses made in the 2008 crash and the subsequent returns achieved by the different indices. From the below, it is clear that an investor who was invested solely in bonds would have experienced a slight uptick during the crash in 2008, but in subsequent years would have struggled to keep up with the returns made by the South African equity market. Investors in a typical money market fund would hardly have experienced any volatility over this period but the graph shows that the performance thereof lags all other investments. While equity markets do experience greater losses, the returns in bull markets typically make up for the initial losses. The chart shows that this is the case, although returns for global equities haven’t been as stellar as local and emerging markets.

Blending different assets classes wisely can have the effect of limiting losses and reducing volatility when compared to a pure equity investment. By investing into multi asset funds (the chart above uses the average Multi Asset – High Equity fund as a proxy) investors are able to reduce their losses in bear markets and then participate in a significant portion of the upside.

The above chart clearly illustrates the different ‘investment journeys’ that investors can take. Should there be a willingness to suffer larger losses over shorter periods, investors can expect to be compensated with excess returns over the long term when compared to lower risk investments.

The above argument is dependent on being invested in an index. Investments in actively managed unit trusts or share portfolios would have resulted in different return profiles that would leave the investor either better or worse off depending on the success of the particular manager.

At Seed we understand that different clients have different needs, especially in terms of the level of risk taken on. Before any investments are made, a recommended strategy unique to the client gets formulated which determines the optimal level of risk that the client should take. The recommended strategy takes into account the entire portfolio, as no investment should be viewed in isolation.

We believe that the limitation of permanent capital losses is vital to the overall success of any investment strategy and are therefore proponents of diversifying into more than one asset class and geographical location. This will take the client on an investment journey that will be more robust in an ever volatile environment.

Seed weekly - Financial Planning 101

I was recently asked by a client of mine if we had any pamphlet material outlining the basics of advice for people who have just started working.

I looked around and couldn’t find much that was satisfactory so I have decided to give a brief summary in financial planning 101. Please note that this is an initial guideline and is not meant to be an exhaustive all-encompassing view. If you do understand financial planning, please forward this to somebody who doesn’t.

The back bone of any financial plan and the foundation of financial wellbeing is a budget. If you spend more than you earn you will never be financially independent no matter how much you earn, I have seen people earning R 300 000 per month net with expenses of R 320 000 per month. A budget is the only instrument which can keep your expenses in check, most people underestimate their expenses.

Every person has three basic financial planning needs namely life cover, disability cover and savings.

Life Cover

There are two basic reasons why a person should have life cover, firstly to cover your debts and liabilities, and secondly to cover your future income stream for your dependents. If you have no dependents and no liabilities you don’t need life cover. Your life cover generally goes in a cycle increasing to a point where you have car debt, house debt and the maintenance of 2.5 kids and reducing as the debts reduce and the kids start becoming financially dependent.

Disability

Disability cover is often sold as a lump sum but income protection is probably the most neglected area of financial planning. No matter what your debt/dependent situation is, if you are earning an income you need to ensure that if you cannot work anymore that income will be covered.

Savings

When looking at savings, there are a number of aspects that need to be taken into account. Short term needs (holidays, large expenses such as car tyres etc.) Medium term savings (saving for a deposit on a house, kids tuition fees etc.) and Long Term savings needs (Retirement). Whilst the numbers may vary it is an indisputable fact that most South African’s cannot retire at anywhere near the lifestyle they had before retirement. Compound interest is an incredibly powerful force and most people who can retire comfortably can do so because they started saving very early in their working lives. It is important that you start early enough and that you save enough. It is pointless putting away R 150 per month starting at the age of 20 but not increasing that amount. I often get asked how much money is needed to retire. This is a very difficult as each person has different income needs, but if you want to retire at the age of 60 a general rule of thumb is that you will need investable capital of 25 times your annual net income needs.

A will is a very important document that will only be used once. If you have any assets you need to have a will. Whilst most people hate thinking about their death a Will is an integral part of any decent financial plan.

The most important thing about being financially dependent is to have a plan, this plan will include a realistic budget, enough life cover (not too much) the right income protection and a properly managed portfolio of short, medium and long term investments. Most people do not have the time or inclination to set up this plan so it is important to have a reputable trustworthy financial advisor to help you achieve your goals. Should you have any further questions, please don’t hesitate to contact me.

Seed weekly - Financial Planning 101

I was recently asked by a client of mine if we had any pamphlet material outlining the basics of advice for people who have just started working.

I looked around and couldn’t find much that was satisfactory so I have decided to give a brief summary in financial planning 101. Please note that this is an initial guideline and is not meant to be an exhaustive all-encompassing view. If you do understand financial planning, please forward this to somebody who doesn’t.

The back bone of any financial plan and the foundation of financial wellbeing is a budget. If you spend more than you earn you will never be financially independent no matter how much you earn, I have seen people earning R 300 000 per month net with expenses of R 320 000 per month. A budget is the only instrument which can keep your expenses in check, most people underestimate their expenses.

Every person has three basic financial planning needs namely life cover, disability cover and savings.

Life Cover

There are two basic reasons why a person should have life cover, firstly to cover your debts and liabilities, and secondly to cover your future income stream for your dependents. If you have no dependents and no liabilities you don’t need life cover. Your life cover generally goes in a cycle increasing to a point where you have car debt, house debt and the maintenance of 2.5 kids and reducing as the debts reduce and the kids start becoming financially dependent.

Disability

Disability cover is often sold as a lump sum but income protection is probably the most neglected area of financial planning. No matter what your debt/dependent situation is, if you are earning an income you need to ensure that if you cannot work anymore that income will be covered.

Savings

When looking at savings, there are a number of aspects that need to be taken into account. Short term needs (holidays, large expenses such as car tyres etc.) Medium term savings (saving for a deposit on a house, kids tuition fees etc.) and Long Term savings needs (Retirement). Whilst the numbers may vary it is an indisputable fact that most South African’s cannot retire at anywhere near the lifestyle they had before retirement. Compound interest is an incredibly powerful force and most people who can retire comfortably can do so because they started saving very early in their working lives. It is important that you start early enough and that you save enough. It is pointless putting away R 150 per month starting at the age of 20 but not increasing that amount. I often get asked how much money is needed to retire. This is a very difficult as each person has different income needs, but if you want to retire at the age of 60 a general rule of thumb is that you will need investable capital of 25 times your annual net income needs.

A will is a very important document that will only be used once. If you have any assets you need to have a will. Whilst most people hate thinking about their death a Will is an integral part of any decent financial plan.

The most important thing about being financially dependent is to have a plan, this plan will include a realistic budget, enough life cover (not too much) the right income protection and a properly managed portfolio of short, medium and long term investments. Most people do not have the time or inclination to set up this plan so it is important to have a reputable trustworthy financial advisor to help you achieve your goals. Should you have any further questions, please don’t hesitate to contact me.

Seed weekly - Financial Planning 101

I was recently asked by a client of mine if we had any pamphlet material outlining the basics of advice for people who have just started working.

I looked around and couldn’t find much that was satisfactory so I have decided to give a brief summary in financial planning 101. Please note that this is an initial guideline and is not meant to be an exhaustive all-encompassing view. If you do understand financial planning, please forward this to somebody who doesn’t.

The back bone of any financial plan and the foundation of financial wellbeing is a budget. If you spend more than you earn you will never be financially independent no matter how much you earn, I have seen people earning R 300 000 per month net with expenses of R 320 000 per month. A budget is the only instrument which can keep your expenses in check, most people underestimate their expenses.

Every person has three basic financial planning needs namely life cover, disability cover and savings.

Life Cover

There are two basic reasons why a person should have life cover, firstly to cover your debts and liabilities, and secondly to cover your future income stream for your dependents. If you have no dependents and no liabilities you don’t need life cover. Your life cover generally goes in a cycle increasing to a point where you have car debt, house debt and the maintenance of 2.5 kids and reducing as the debts reduce and the kids start becoming financially dependent.

Disability

Disability cover is often sold as a lump sum but income protection is probably the most neglected area of financial planning. No matter what your debt/dependent situation is, if you are earning an income you need to ensure that if you cannot work anymore that income will be covered.

Savings

When looking at savings, there are a number of aspects that need to be taken into account. Short term needs (holidays, large expenses such as car tyres etc.) Medium term savings (saving for a deposit on a house, kids tuition fees etc.) and Long Term savings needs (Retirement). Whilst the numbers may vary it is an indisputable fact that most South African’s cannot retire at anywhere near the lifestyle they had before retirement. Compound interest is an incredibly powerful force and most people who can retire comfortably can do so because they started saving very early in their working lives. It is important that you start early enough and that you save enough. It is pointless putting away R 150 per month starting at the age of 20 but not increasing that amount. I often get asked how much money is needed to retire. This is a very difficult as each person has different income needs, but if you want to retire at the age of 60 a general rule of thumb is that you will need investable capital of 25 times your annual net income needs.

A will is a very important document that will only be used once. If you have any assets you need to have a will. Whilst most people hate thinking about their death a Will is an integral part of any decent financial plan.

The most important thing about being financially dependent is to have a plan, this plan will include a realistic budget, enough life cover (not too much) the right income protection and a properly managed portfolio of short, medium and long term investments. Most people do not have the time or inclination to set up this plan so it is important to have a reputable trustworthy financial advisor to help you achieve your goals. Should you have any further questions, please don’t hesitate to contact me.

Seed weekly - Active and Passive Investment Strategies

Monday’s Business Day had an article on passive investing, with the headline “passive investment relies on getting a free ride from active managers.” The basic emphasis of the article was - only because active investors are performing an invaluable service of price discovery, can passive investors essentially ride on their coat-tails. The article points out, and quite rightly so, that “If the whole world were investing passively, prices would not move.”

Let’s take a cursory view of active, passive, and smart beta managers.

Active Management

Investopedia defines active management as the use of human element to actively manage an investment portfolio, through the use of analytical research, forecasts, judgement and experience, deciding which shares to buy, hold and sell and in what proportions.

The underlying premise that drives active management, is that market prices are not absolutely efficient and so, by employing human skill and ingenuity, a portfolio of shares can be constructed which will outperform a simple index. Investors making use of active management want to capture both beta (i.e. the market returns) and alpha (the additional performance that the manager is able to achieve).

Passive Management

A passive investment management strategy is one where a portfolio of shares is constructed by mirroring an index. Two further subsets of this strategy are – Market Cap Weighted and Smart Beta.

Market Cap
The traditional index – such as the FTSE/JSE All Share index is constructed on the basis of market capitalisation, or relative size of the underlying companies, so that a large company such as Billiton has an 11.8% weight in the index, while a smaller company such as Goldfields has a 0.74% weight in the same index.

The underlying premise that drives investors to make use of market cap weighted index tracking portfolios is the belief that market prices are efficient and therefore over longer periods of time it is impossible for active managers to outperform, especially after taking their higher costs into account. Investors into these passive strategies want to only capture market performance, known as beta, but at low cost.

Smart Beta
Somewhere between a pure index passive and the active management is smart beta. By constructing an index in a different manner to purely the relative sizes of the companies, a smart beta portfolio aims to provide investors with market exposure (i.e. beta) plus the ability to outperform – i.e. some alpha as well.

There are many ways in which smart beta portfolios can be constructed. Three methodologies used include:
• Equally weighted approach – this removes the link between share prices and their weights. Shares in a given universe are weighted equally in a portfolio.
• Economic weighted – here certain fundamental factors are used to weight the shares. These can include sales, earnings, dividends etc.
• Factor tilts – here the weights in the portfolio are constructed by looking at specific return drivers that are typically used by active managers when compiling their portfolios. These would include value factors such as earnings yield and dividend yield, and perhaps also momentum factors such as earnings upgrades.

Over time certain smart beta strategies have shown to deliver superior performance when compared to the pure market cap passive (read FTSE/JSE All Share index) and indeed when when compared against many active managers. All investors looking to generate returns above the benchmark, but at lower costs, should be considering a smart beta component.

The Seed Equity fund is a unit trust that tracks value and momentum factors on a passive approach (i.e. a smart beta fund). If you would like to find out more, please don’t hesitate to give us a call.

Seed weekly - Active and Passive Investment Strategies

Monday’s Business Day had an article on passive investing, with the headline “passive investment relies on getting a free ride from active managers.” The basic emphasis of the article was - only because active investors are performing an invaluable service of price discovery, can passive investors essentially ride on their coat-tails. The article points out, and quite rightly so, that “If the whole world were investing passively, prices would not move.”

Let’s take a cursory view of active, passive, and smart beta managers.

Active Management

Investopedia defines active management as the use of human element to actively manage an investment portfolio, through the use of analytical research, forecasts, judgement and experience, deciding which shares to buy, hold and sell and in what proportions.

The underlying premise that drives active management, is that market prices are not absolutely efficient and so, by employing human skill and ingenuity, a portfolio of shares can be constructed which will outperform a simple index. Investors making use of active management want to capture both beta (i.e. the market returns) and alpha (the additional performance that the manager is able to achieve).

Passive Management

A passive investment management strategy is one where a portfolio of shares is constructed by mirroring an index. Two further subsets of this strategy are – Market Cap Weighted and Smart Beta.

Market Cap
The traditional index – such as the FTSE/JSE All Share index is constructed on the basis of market capitalisation, or relative size of the underlying companies, so that a large company such as Billiton has an 11.8% weight in the index, while a smaller company such as Goldfields has a 0.74% weight in the same index.

The underlying premise that drives investors to make use of market cap weighted index tracking portfolios is the belief that market prices are efficient and therefore over longer periods of time it is impossible for active managers to outperform, especially after taking their higher costs into account. Investors into these passive strategies want to only capture market performance, known as beta, but at low cost.

Smart Beta
Somewhere between a pure index passive and the active management is smart beta. By constructing an index in a different manner to purely the relative sizes of the companies, a smart beta portfolio aims to provide investors with market exposure (i.e. beta) plus the ability to outperform – i.e. some alpha as well.

There are many ways in which smart beta portfolios can be constructed. Three methodologies used include:
• Equally weighted approach – this removes the link between share prices and their weights. Shares in a given universe are weighted equally in a portfolio.
• Economic weighted – here certain fundamental factors are used to weight the shares. These can include sales, earnings, dividends etc.
• Factor tilts – here the weights in the portfolio are constructed by looking at specific return drivers that are typically used by active managers when compiling their portfolios. These would include value factors such as earnings yield and dividend yield, and perhaps also momentum factors such as earnings upgrades.

Over time certain smart beta strategies have shown to deliver superior performance when compared to the pure market cap passive (read FTSE/JSE All Share index) and indeed when when compared against many active managers. All investors looking to generate returns above the benchmark, but at lower costs, should be considering a smart beta component.

The Seed Equity fund is a unit trust that tracks value and momentum factors on a passive approach (i.e. a smart beta fund). If you would like to find out more, please don’t hesitate to give us a call.